Debt is an essential tool to help companies maintain operations and grow. It is also a double-edged sword that can ruin a company if not managed correctly. Too much debt can push your business to the point of failure. Avoiding a debt problem is much easier than fixing one.
There is no ideal level of debt that works for every economic environment. Furthermore, there is no consensus on what qualifies as a safe level of debt. It’s easy to see why so many companies get into trouble. Here are some approaches to managing debt that work well and are simple to apply.
How to look at debt
Why do construction companies incur debt? The most common reason for using debt is to finance large purchases needed to operate the business. Alternatively, construction companies may also turn to debt to finance growth opportunities.
While there may be other reasons to use debt, such as increasing your return on equity, if you are engaging in those strategies, I assume you are working with a qualified adviser.
Debt to operate the business. Essential to your business, this type of debt is often used for capital expenses. For example, construction companies need vehicles and machinery to operate the business, and these items must be replaced periodically. These purchases are not optional. Without them, you will eventually go out of business.
Few companies have the resources to make these large purchases in cash. They finance these purchases with debt. Consequently, you may need to incur this debt to stay in business.
Debt to grow the business. This type of debt is used to pursue “optional” growth opportunities, which are not essential to staying in business. Instead, you pursue these opportunities to increase your profits. Examples of growth opportunities include expanding into new service areas, launching new products and acquiring other companies.
Using debt to finance growth carries a higher risk because the opportunities are optional but could have a significant negative impact if they fail.
Prioritizing stability versus driving growth
All business owners aim for lasting stability coupled with significant revenue growth. The problem is that these two objectives are usually contradictory. Growth usually comes at the expense of stability and vice versa.
Typically, a strategy that focuses on significant growth uses debt. Higher debt loads are risky because they increase exposure to serious financial problems. Consequently, this strategy affects your company’s stability.
In contrast, a strategy focusing only on stability minimizes risk and growth potential. The company incurs essential debt only to stay in business, and growth opportunities are not pursued or financed. This strategy improves stability but at the expense of growth.
Focusing solely on one approach may not be a good long-term choice. Instead, find a balance that works for you.
The slow and steady approach
A preferred strategy is to focus on slow and steady growth. It allows you to concentrate on stability while pursuing growth selectively, keeping risk at bay.
A slow and steady approach requires discipline and patience. It can work well for owners with a long-term horizon who may want to pass the company to the next generation.
Focus on maintaining and improving operations until you spot an opportunity with high reward potential but low risk. This approach limits your use of debt to finance growth since you pursue only the most attractive projects.
Great opportunities don’t come along often, but we all see a few in our careers. And you don’t need many of them to achieve outstanding results.
Don’t underestimate the power of slow growth over the long term. An average growth rate of 5% per year may look unimpressive. However, after 15 years, the business will have doubled in size. Not bad for a small business.
Timeless takeaways
Companies with serious financial problems have some similarities. Many never had a good cash reserve, had loaded up on debt, or both.
Have a large cash reserve. Small companies typically have tight cash reserves. This lack of cash exposes companies to financial problems if something goes wrong. While some business owners see cash reserves as idle money that could be invested in growth, a large cash reserve should be considered a dependable safety net.
Avoid easy debt. Companies can easily get into debt, and several products provide quick financing with minimal documentation. However, there is a catch—these loans are usually expensive, have onerous terms and can be misused. Some companies get additional loans before paying off the previous ones, resulting in several open loans with payments that exceed the company’s ability to pay them. This scenario usually ends badly.
